A break-even analysis is an economic tool that is used to determine the cost structure of a company or the number of units that need to be sold to cover the cost. Break-even is a circumstance where a company neither makes a profit nor loss but recovers all the money spent.
The break-even analysis is used to examine the relation between the fixed cost, variable cost, and revenue. Usually, an organisation with a low fixed cost will have a low break-even point of sale.
Importance of Break-Even Analysis
- Manages the size of units to be sold: With the help of break-even analysis, the company or the owner comes to know how many units need to be sold to cover the cost. The variable cost and the selling price of an individual product and the total cost are required to evaluate the break-even analysis.
- Budgeting and setting targets: Since the company or the owner knows at which point a company can break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This analysis can also be practised in establishing a realistic target for a company.
- Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The break-even analysis helps the company to decide the least number of sales required to make profits. With the margin of safety reports, the management can execute a high business decision.
- Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost. Therefore, with break-even analysis, the management can detect if any effects are changing the cost.
- Helps to design pricing strategy: The break-even point can be affected if there is any change in the pricing of a product. For example, if the selling price is raised, then the quantity of the product to be sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to sell extra to break-even.
Components of Break-Even Analysis
- Fixed costs: These costs are also known as overhead costs. These costs materialise once the financial activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation cost, labour cost, interests, energy cost, etc.
- Variable costs: These costs fluctuate and will decrease or increase according to the volume of the production. These costs include packaging cost, cost of raw material, fuel, and other materials related to production.
Uses of Break-Even Analysis
- New business: For a new venture, a break-even analysis is essential. It guides the management with pricing strategy and is practical about the cost. This analysis also gives an idea if the new business is productive.
- Manufacture new products: If an existing company is going to launch a new product, then they still have to focus on a break-even analysis before starting and see if the product adds necessary expenditure to the company.
- Change in business model: The break-even analysis works even if there is a change in any business model like shifting from retail business to wholesale business. This analysis will help the company to determine if the selling price of a product needs to change.
Break-Even Analysis Formula
Break-even point = Fixed cost/-Price per cost – Variable cost
Example of break-even analysis
Company X sells a pen. The company first determined the fixed costs, which include a lease, property tax, and salaries. They sum up to ₹1,00,000. The variable cost linked with manufacturing one pen is ₹2 per unit. So, the pen is sold at a premium price of ₹10.
Therefore, to determine the break-even point of Company X, the premium pen will be:
Break-even point = Fixed cost/Price per cost – Variable cost
= ₹1,00,000/(₹12 – ₹2)
Therefore, given the variable costs, fixed costs, and selling price of the pen, company X would need to sell 10,000 units of pens to break-even.
The above-mentioned is the concept of ‘Break-Even Analysis’. To know more, stay tuned to our website.